The US Federal Reserve has again delayed raising interest rates, and medium-term forecasts of the Fed rate have been tumbling. The European Central Bank is poised to extend its quantitative easing policies beyond March 2017, and the Bank of Japan has started to target the long-term yield directly.
In the UK, the Bank of England may cut its policy rate further below 0.25%. Not since the Bank of England rate flat-lined at 2% in the 1930s has there been any period like this.
Interest rates are important because they affect not just banks, but also savers, borrowers, insurers and pension funds, and the government. They also impact the pace of the business cycle, and even decisions around logistics and working capital. They determine the pricing of assets and liabilities across many sectors of the economy and the financial flows between them. Even small shifts in long-term rates such as mortgages and lending rates to business impart a powerful kick to the economy.
Why Are Interest Rates So Low?
Since the last financial crisis, powerful secular and cyclical trends have converged with the economic philosophy at central banks to bring short- and long-term rates to historic or unprecedented lows across the advanced economies.
One factor often cited is demographics: Working-age population growth in rich countries has slowed, while working-age population growth in poor countries has risen. Other factors include “excess” emerging-market savings, cheaper capital goods, and a lack of public investment.
The simplest explanation is that the financial crisis reduced both the potential growth rate of the economy and inflation expectations. Therefore, the theoretical “neutral” policy rate that keeps the economy expanding at a long-term sustainable rate, without inflation, has been depressed to low or even subzero levels.
Who Wins and Who Loses from a 1% Move in Rates?
Banks would suffer from interest-rate normalization as their deposit financing costs would rise. US banks are better poised to deal with this challenge than European banks due to their higher profitability. British, Italian, Portuguese, and German banks would have seen all their pretax profits wiped out if their deposit financing costs had risen by a percentage point in 2015.
Banks also suffer from low borrowing rates at the long end, depressing their net interest margins and hence their profits. Banks are thus vulnerable to shocks in either direction for interest rates, if their net interest margins remain depressed.
A 1% rise in deposit rates and a 1% rise in mortgage rates might just about offset each other in some European economies. However, the impact would vary in line with the tax status of depositors, the proportion of fixed-rate mortgages, and the importance of the mortgage market in each economy.
Meanwhile, for bonds, interest-rate rises are unequivocally toxic. For a portfolio of UK government bonds, weighted the same in maturity terms as the overall stock of UK government conventional debt, a 1% rise in yields on all maturities would visit an approximate 10% loss. The loss would range up to an 18% drop in value for a gilt (a bond issued by the British government that is generally considered low risk and similar to US Treasury securities) maturing in 2046. Similar losses would apply to other European government bonds.
Impact on Insurers, Pension Funds
Both life insurers (given annuities paid to beneficiaries) and pension funds have long-term, often fixed liabilities. Their liabilities increase faster than the value of their assets when the discount rate in the form of government bond yields falls, potentially widening balance sheet gaps. If liabilities are long-term, while assets are short-term, the mismatch intensifies the effects of rate falls.
Longevity risks for pension funds and life insurers (once annuities they pay out outweigh their life policies) also become more acute with low interest rates. This is an issue that will increasingly weigh on players from CalPERS to the UK Pension Protection Fund.
Looking at the winners and losers from the scenarios of interest-rate normalization and further policy easing results is a difficult calculus for policy makers.
Interest Rate Changes Pose Tough Choices
If rates are lower for longer, then savers, insurers, pension funds, and future pension beneficiaries get hit through lower deposit income and growing asset-liability mismatches, as long-term liabilities grow faster in low interest-rate contexts. In contrast, with rates lower for longer, bondholders, the government, and mortgage borrowers get shielded.
The worst-case scenario is that ultralow or negative interest rates are prolonged and that future pension fund beneficiaries, after lifetimes of work, see their claims devalued. This outcome could be replicated in economies across the Organisation for Economic Co-operation and Development (OECD) if rates stay lower for longer as policy makers insist on avoiding the short-term financial market volatility that rising rates can bring.